Earnings Call Transcript - WCC Q2 2023

Operator, Operator

Hello and welcome to WESCO's Second Quarter Earnings Call. I would like to remind you that all lines are in listen-only mode throughout the presentation. Please note that this event is being recorded. I would now hand the call over to Scott Gaffner, Senior Vice President, Investor Relations to begin.

Scott Gaffner, Senior Vice President, Investor Relations

Thank you and good morning. Before we get started, I want to remind you that certain statements made on this call contain forward-looking information. Forward-looking statements are not guarantees of performance and, by their nature, are subject to inherent uncertainties. Actual results may differ materially. Please see our webcast slides as well as the company's SEC filings for additional risk factors and disclosures. Any forward-looking information relayed on this call speaks only as of this date and the company undertakes no obligation to update the information to reflect the changed circumstances. Additionally, today, we will use certain non-GAAP financial measures. Required information about these non-GAAP measures is available on our webcast and in our press release, both of which are posted on our website at wesco.com. On the call this morning, we have John Engel, WESCO's Chairman, President and Chief Executive Officer; and Dave Schulz, Executive Vice President and Chief Financial Officer. Now I'll turn the call over to John.

John Engel, Chairman, President and CEO

Thank you, Scott. Good morning, everyone, and thank you for joining the call today. The power of our portfolio and mix-shift into higher growth markets is clear in our record second quarter sales, although sales were below our expectations in the quarter due to our EES business. Continued strong growth and record sales in our CSS and UBS businesses more than offset a quarterly drop in our EES business. The decline in EES was largely the result of unprecedented supply chain rebalancing in the electrical industry, leading to customer destocking, along with weakness in certain sectors, including commercial construction and manufactured structures. Our long-term secular growth drivers remain intact and they are reflected in our continued sales growth in the utility, data center, security and industrial sectors. On the strength of our industry-leading customer value proposition, strong cross-sell execution continued in the quarter and we're now raising our sales synergy target again we've had a series of these, a string of these since we put the two companies together, we're raising it from $1.8 billion to $2 billion. Lead times for most product categories have returned to 2019 levels. The extraordinary supply chain disruptions and customer purchase patterns driven by the pandemic over the last few years are now correcting with the rapid reduction in supplier lead times. Against these supply chain rebalancing conditions, our gross margins remain healthy and stable. While economic conditions remain positive, consistent with the soft landing, we did see pockets of underperformance in certain end markets served by our EES business. Even with the increased overall sales in the second quarter, I'm very happy to say our free cash flow generation of $293 million was very strong and brought us back in the positive territory for the first half of 2023, and that's back in line with our expectations. During the second quarter, we reduced our inventories and we paid down debt. Our financial leverage now stands at 2.8 times, near the midpoint of our target range, and it is the lowest level since the Anixter acquisition in June 2020. Given our anticipated free cash flow generation in the second half of 2023, we stand in a very good position to use that cash flow to increase value to our shareholders with stock buybacks and that is our plan. We remain confident in and focused on the transformational steps that we are taking to improve our digital capabilities, capture additional market share and create value for all our stakeholders. We continue to invest in our digital transformation plan, and we are working to deliver digital capabilities to benefit our customers and supplier partners that will be game-changing. We've already taken steps to address our cost versus current market conditions through the $25 million annualized cost reduction set of actions. They were taken in June and they will begin to benefit our second half. Given our EES results in the second quarter, we are revising our full year outlook. It is important to note that our revised outlook still delivers record sales, record EBITDA and record free cash flow on a full-year basis at the midpoint. The power of WESCO's scale, industry-leading positions and expanded portfolio of product services and solutions positions us to capture the benefits of enduring secular growth trends as well as the anticipated increased infrastructure investments in North America. We are committed to and remain very confident in our ability to deliver the financial objectives presented at our Investor Day, including our long-term margin expansion, profit growth and cash generation targets. Now turning to page four. The strength of our business model and the success of our integration efforts since closing the Anixter acquisition in mid-2020 have established a track record of exceptional results for our company. Our second quarter results compared to the pro forma pre-pandemic results of legacy WESCO plus legacy Anixter in the second quarter of 2019 clearly highlight the successful combination of these two Fortune 500 companies. Over the past three years, we have been outperforming the market, delivering impressive sales growth and margin expansion, all while rapidly deleveraging our balance sheet. The combination of these two organizations has led to a more diverse portfolio of higher growth and higher-margin businesses with deep exposure to long-term secular growth trends that will drive our future sales and profitability. With that I will now turn the call over to Dave.

David Schulz, Executive Vice President and CFO

Thanks, John. I'll start on slide five with a summary of our second quarter results compared to the prior year. As John mentioned, the company delivered record second quarter sales. Year-over-year increases in our CSS and UBS businesses were partially offset by a decline in sales in certain EES markets. On an organic basis, sales were up 3% over the prior year, driven mostly by a low single-digit contribution from price as volume was flat. The flat volumes in the quarter represent a modest year-over-year decline in market volume that was fully offset by our strong cross-sell results. During the quarter, we experienced some negative impacts from supply chain rebalancing and the normalization of product lead times. As lead times extended at the start of the pandemic, customers increased purchases to offset the impact. As the supply chain heals, we are now seeing a rapid reversal of those behaviors, which has led to destocking and a temporary decline in our stock and flow activity levels in certain customer verticals, while underlying end market growth remains stable. Project backlog continues to be at historically high levels, supporting our outlook in the second half of 2023 into 2024 and beyond. In total, backlog was up 6% year-over-year and down approximately 2% sequentially from the end of March. Gross margin of 21.6% was stable year-over-year after adjusting for the impact of business unit mix during the quarter. We continue to prioritize profitable top line growth. And, as the industry leader, we intend to protect the progress we've made on gross margin with continued execution of our enterprise-wide margin improvement program. Adjusted EBITDA was flat with the prior year. Higher SG&A costs, which have been addressed through our cost-reduction actions was the primary driver of the reduction in EBITDA margins year-over-year. Adjusted diluted EPS for the quarter was $3.71, 11% below the prior year as the contribution from Rahi was offset by foreign exchange rates, higher interest expense, a higher effective tax rate and higher share count. As we start the third quarter, end market demand trends are sequentially in line with the seasonality of the past two years. July preliminary sales were up 3% with growth in CSS and UBS, partially offset by a decline in EES, driven by construction and OEM, consistent with what we experienced in the second quarter.

John Engel, Chairman, President and CEO

Turning to page six. This slide bridges the year-over-year changes in sales and adjusted EBITDA. As I mentioned a moment ago, organic sales increased 3% versus the prior year, including a 3% benefit from price, while volumes were roughly flat. Market volumes declined and were offset by higher incremental cross-sell gains. As expected, the contribution from price moderated again in the quarter relative to 2022 as there have been fewer supplier price increases and the magnitude of these increases has been smaller. Additionally, decreases on pure commodity products was a headwind to pricing in the quarter. Adjusted EBITDA was flat versus the prior year as the benefit of higher sales was offset by higher compensation and volume-related costs and higher costs associated with our digital and IT transformation. We have already taken steps to address the higher costs through a series of actions taken in June that will benefit the second half of the year. These actions will generate $25 million of annualized cost savings. Turning to slide seven. Organic sales in our EES business were down 5% year-over-year or down 3% excluding the impact of the intersegment business transfers that we initiated in the first quarter. The 3% like-for-like reduction in sales versus the prior year was primarily driven by the combination of two factors. First, construction was down mid-single digits due to supply chain rebalancing, leading to lower stock and flow sales with contractor customers as well as lower wire and cable sales. Second, we experienced continued weakness in manufacturing structures in our OEM operating group. Our industrial sales were up low single-digits driven by continued growth in general industrial, metals and mining and petrochemical markets. Backlog was up 9% over prior year, up 3% sequentially, driven by strong bookings for large projects. More than a third of the backlog supports top line growth in 2024 and beyond as we are now beginning to win larger mega projects associated with the unprecedented levels of infrastructure investments in North America. In the second quarter, adjusted EBITDA was down approximately 20% from the prior year. Adjusted EBITDA margin was 8.6%, 150 basis points lower year-over-year. The reduced profitability in EES was driven by the lower sales level and higher SG&A. We expect EES adjusted EBITDA margins to improve modestly in the second half of the year, driven by operating leverage on seasonally higher sales, along with the SG&A reductions initiated in the second quarter. Turning to slide eight. I mentioned that EES backlog was up in the quarter driven by larger project wins. This page provides an example of the scale, scope and power of one of those mega project wins. We were awarded a $120 million multiyear contract to support the construction of a new electric vehicle manufacturing facility. The initial award was specifically focused on switchgear. However, due to our total solutions offering and cross-sell initiatives, we were able to substantially increase the scope of products and solutions that we are supplying. This project win is an excellent example of the success of both our cross-sell program and the secular trends of electrification and reshoring. Shipments are scheduled to begin in the second half of this year.

David Schulz, Executive Vice President and CFO

Turning to slide nine. Sales in our CSS business were a quarterly record and up 16% versus the prior year on a reported basis. Organic sales were up 7%. We saw good growth in network infrastructure, up low double-digits, driven by data center and cloud applications. We saw substantial growth to hyperscale data center customers, driven by both Rahi and growth in our legacy data center business. Sales to Internet service providers who supply 5G, fiber and satellite connectivity were down mid-single digits. Security sales were up high single-digits and professional audio-visual installations were also up double digits, driven by strong international sales. Profitability was also strong with record Q2 adjusted EBITDA and adjusted EBITDA margin of 9.7%, 30 basis higher than the prior year, driven by operating leverage, integration cost synergies and the continued successful execution of our margin improvement initiatives. Turning to slide 10. We noted the strong growth in data center demand for CSS in the quarter. The long-term trends remain healthy as global data center customers provide dynamic and exciting business opportunities due to accelerating data consumption, increased adoption of the cloud and ongoing demand for data storage and management. As our data center customers increased their scale, footprint, scope and complexity, our ability to service them as the best tech-enabled supply chain solutions provider is paramount. With our new WESCO data solutions team, inclusive of Rahi, we provide more solutions and focused expertise around the clock and around the world. This business enables us to support all data center environments, including the rapidly expanding AI-driven new build and upgrades by offering complete end-to-end product and service solutions and supporting customers on a global basis. The combined sales of this business represent approximately half of our network infrastructure revenue and is on track to reach approximately $2 billion in sales by the end of the year, with an outlook for strong double-digit growth in 2024 and beyond. Turning to slide 11. Record sales in our UBS business were up 10% versus the prior year on an organic basis in the quarter. We experienced broad-based growth in utility, up low double digits and integrated supply up mid-teens versus the prior year. Broadband sales were down low double digits as certain customers continue to work through inventory and delay restocking until government infrastructure funds are allocated. We now expect broadband sales growth to resume in 2024 as customers and the supply chain continue to work through inventory rebalancing and destocking in the second half of this year. Backlog was up 15% over the prior year and down approximately 2% on a sequential basis. Profitability was exceptionally strong with a Q2 record adjusted EBITDA margin of 11.1%, up 20 basis points versus the prior year, driven by operating leverage on higher sales, our margin improvement initiatives and integration synergies. This was the fifth consecutive quarter of adjusted EBITDA margins above 10%. Turning to slide 12. As we have said before, the Utility business has some of the strongest secular trends of any of our businesses. Three of the most significant secular trends that are driving growth in our utility business, grid hardening and modernization, investments in renewable power sources and the need for increased grid capacity are a reality today. As we mentioned at our Investor Day last fall, we are seeing the acceleration of grid modernization trends. The U.S. electric grid will require up to $2 trillion of investments over the next 10 years merely to sustain the current level of reliability. That, combined with direct government funding for investments in renewable generation will continue to provide outstanding growth opportunities for our Utility business for many years to come. Collectively, we expect that these trends will double historical utility industry growth rates over the long term.

John Engel, Chairman, President and CEO

Now moving to page 13. The size of the cross-sell opportunity continues to exceed our expectations. This quarter, we recognized more than $300 million of cross-sell revenue, the highest in the 12 quarters since acquiring Anixter, and bringing the cumulative total to $1.75 billion since the beginning of the program. Our pipeline of sales opportunities remains healthy and expanded again in the quarter. We are capitalizing on the complementary portfolio of products and services as well as the minimal overlap between legacy WESCO and legacy Anixter customers. As we look at the remaining six months of the program in 2023, we are increasing our expected cumulative total to $2 billion, reflecting the strength of our value proposition against the backdrop of accelerating secular trends.

David Schulz, Executive Vice President and CFO

Turning to page 14. This is a slide that we've shown throughout the integration with the realized cumulative run rate cost synergies of $188 million in 2021 and $270 million in 2022. We remain on track to meet our expected target of $315 million by the end of 2023. Our focus through the balance of the year is on supply chain network optimization and field operations to drive cost synergies. Turning to page 15. Recall that after our cash draw in the first quarter, we said we expected to generate significant free cash flow in the second quarter and be approximately neutral through the first half of the year. We generated $293 million of free cash flow in the second quarter or 141% of adjusted net income and are now positive on a year-to-date basis. The primary driver was working capital management, specifically lower inventory, which represented a source of cash of $150 million. Moving to slide 16. Reducing our leverage has been a top priority since we announced the acquisition of Anixter and we are pleased that leverage is now at its lowest level since closing the transaction in June of 2020. Notable this quarter was that our strong cash flow enabled us to reduce net debt by more than $250 million, which was the primary driver of the lower leverage. We previously indicated our intent to operate with leverage at the midpoint of our targeted range of 2 times to 3.5 times trailing 12-month EBITDA, and we expect to reach the midpoint in the second half of the year. Given that we are close to our target leverage ratio, our capital allocation priorities will be more balanced between share repurchases and debt reduction. Based on the current interest rate and economic environment, we will look to continue paying down debt while opportunistically funding share buybacks in the second half of 2023. Now moving to page 17. This slide shows the uniquely strong position of our company to drive growth and profitability in the years ahead. The end-to-end solutions that we provide to our global customer base are directly aligned with the six secular growth trends shown on the left side of this page. Our participation in these trends, coupled with increasing public sector investments in infrastructure, broadband and partnerships with the private sector, position WESCO exceptionally well. As we outlined at our Investor Day last year, we expect to grow 2% to 4% above the market due to the combined benefit of secular trend growth and increasing share. Moving to page 18. We are updating our 2023 outlook today based on the results of the first half of the year and current market conditions. For the year, we now expect organic sales to be up approximately 4% to 6% versus 5% to 8% previously. The change in our outlook is entirely driven by a downshift in our expectation for market volume growth. We now expect our market volumes to be relatively flat year-over-year as gains in CSS and UBS are offset by declines in EES, with price driving total market growth of approximately 3% to 4%. Our share gains and cross-sell initiatives remain a powerful driver of our performance and will provide another one to two points of organic growth. After factoring in the additional revenue from Rahi, the impact of one less workday in 2023 and the impact of foreign exchange rate differences, we estimate our reported sales growth will be in the range of 5% to 7%. For our strategic business units, we now expect EES reported sales to be approximately flat year-over-year, versus our prior expectation for mid-single-digit growth. As we noted earlier, we have experienced headwinds in our EES markets that were largely the result of unprecedented supply chain rebalancing that drove customer destocking in the electrical industry, along with select weakness in certain sectors, including the stock and flow portion of commercial construction and manufactured structures. Our outlook for UBS remains unchanged from our prior outlook, with top line expected to be up high single to low double digits. And lastly, for CSS, we now expect reported sales to be up mid-teens year-over-year versus our prior expectation of high single to low double-digit growth. For adjusted EBITDA margin, our outlook is for a range of 7.8% to 8%, which represents a decline of approximately 30 basis points at the midpoint. This primarily reflects the top line and SG&A margin headwinds experienced within EES. We took actions to address total company costs in June, which will have an annualized benefit of $25 million. Gross margin in the first half of 2023 was stable year-over-year. Sequentially, we expect stable gross margin in the second half of the year as we overcome notable year-over-year headwinds related to supplier volume rebates. Based on current assumptions, supplier volume rebates in the second half will be a headwind of approximately 40 basis points. With the lower EBITDA forecast, we are also reducing our outlook for adjusted earnings per share to $15 to $16 and free cash flow between $500 million and $700 million. Despite the lower expectations for the remainder of the year, this outlook still reflects record adjusted EBITDA, record adjusted diluted EPS and a record free cash flow at the midpoint of their respective ranges. In the appendix of this presentation, we have shown our revised underlying assumptions for certain items on the income statement. We increased the low end of our expectation for interest expense for the year from a range of $350 million to $390 million, to a range of $370 million to $390 million, primarily driven by higher variable rates and the timing of debt paydown in 2023. Additionally, we now expect other expense to be approximately $20 million to $30 million for the full year versus $30 million to $40 million previously. Regarding the quarterly cadence in the back half of the year, we expect Q3 reported revenue to be down low single digits sequentially. This is in line with the quarterly cadence in 2022 and the trends we experienced in July. In addition, there is one less workday in Q3 versus Q2. Similar to the last two years, we are expecting a low single-digit sequential increase in revenue in the fourth quarter versus the third quarter.

John Engel, Chairman, President and CEO

Before opening the call for questions, let me provide a brief summary of what we covered this morning. Overall sales were below our expectations in the second quarter. We delivered record sales in both CSS and UBS, which more than offset the impact of supply chain rebalancing and select market weakness within EES. We again took share in most of our operating groups through sales execution in our cross-sell program, and we are again increasing our cross-sell synergies outlook for 2023. Free cash flow was particularly strong in the quarter as we delivered approximately $300 million of cash flow, bringing our year-to-date total to positive. We reduced our leverage this quarter to the lowest level since acquiring Anixter in 2020 and we are approaching the midpoint of our target range. We expect to generate significant cash flow in the second half of the year, enabling continued investment in our strategic objectives and increasing shareholder returns. We continue to expect 2023 will be a transformational year with continued execution of our digital initiatives, strong sales growth and substantial cash generation supporting our value creation initiatives. With that, we'll open the call to your questions.

Operator, Operator

Thank you. We will now begin the question-and-answer session. Today's first question comes from Deane Dray at RBC Capital Markets. Please go ahead.

Deane Dray, Analyst

Thank you. Good morning, everyone.

John Engel, Chairman, President and CEO

Hello, Deane.

Deane Dray, Analyst

Maybe we can start with your expectations about the timing of the destocking process, how long do you think it takes in terms of quarters. Well, we've been asking the manufacturers, and many of them your suppliers, they're saying they're releasing buffer inventory in a process of over several quarters. So would be interested in hearing your perspective how long do you think this process takes?

John Engel, Chairman, President and CEO

Thank you for the question, Deane. The process began in CSS during the second half of last year. As you may recall, CSS's results were slightly below our expectations in terms of momentum compared to both EES and UBS. For CSS, the process is largely complete, and supplier lead times have returned to pre-pandemic levels, which is encouraging. EES started to show improvement at the end of last year, and this momentum has picked up significantly moving into this year, especially in the second quarter. I want to highlight that our EES comparisons are particularly challenging from March to June this year, as last year, EES's strongest quarter was Q2. We expect to see growth return in the second half of this year for EES based on market conditions and the strength of our backlog. We confidently believe that EES has excellent long-term growth potential, driven by the trends Dave mentioned in his comments. Regarding UBS, we also experienced strong results in the quarter, especially in utility and our integrated supply business. In Broadband, we encountered some expected challenges in the value chain during the second quarter. Initially, we anticipated a recovery in the second half, but now we think that is pushed out to next year. I hope this gives you a clear overview by business. Is that helpful?

Deane Dray, Analyst

Yes, it does give a sense of the calibration by segment. But the duration, most of it's happening in EES this quarter, any sense of the percent of that de-stocking that has happened so far?

John Engel, Chairman, President and CEO

Yes. Let's discuss duration. Following the pandemic, as the supply chain stabilizes, we are experiencing what I would describe as a whipsaw effect, marked by a rapid decrease in supplier lead times. This change allows customers, especially contractors in EES, to postpone their purchases related to our stock and flow operations. This trend was evident in EES in the second quarter, where our project sales increased while stock and flow sales declined, primarily in the wire and cable segment. It's also worth mentioning that EES's backlog increased sequentially in Q2, reflecting recent successes in landing larger projects, which is promising for 2024 and beyond. In previous quarters, we received inquiries about when we would start seeing significant wins tied to the two bills passed by Congress related to these larger projects. Initially, we expected no substantial wins until next year, but we are encouraged by the recent achievements in this quarter, including one highlighted in our webcast materials. Shipments for these projects are set to begin in the second half of this year. Therefore, we anticipate a rebalancing of conditions throughout the third quarter and a return to a more normalized value chain by the fourth quarter. I believe CSS is reaching that state, and EES is making progress despite the challenges it faced in Q2. That's our perspective.

Deane Dray, Analyst

All right. John that was exactly what I was looking for. That's also the time frame that we're thinking. And just so we're clear, this idea of the shortening of lead times and normalization of supply chain, this is the risk that happens, all this buffer inventory gets released. You're at the end of that whip of this, we get it. And as long as end market demand stays strong, you've got to weather this period of destocking. We get that. We flagged that as a big risk for the whole sector this quarter. We're fine there. But I did want to touch on my follow-up question on the demand side, just the end market demand and the weaker commercial construction. And thank you for flagging that, that is the stock and flow business, not related to projects. So that is destocking related in the stock and flow business, it's not any sort of project delays or labor issues or weather or anything like that?

John Engel, Chairman, President and CEO

Correct. I want to emphasize that our project business within EES, which consists of project and stock employment, has shown year-over-year growth in Q2, and our backlog has increased sequentially. We believe that our EES business, particularly in construction and solutions, is well-positioned to take advantage of ongoing trends. However, the stock and flow segment of the EES business experienced a decline, greater than the overall reported year-over-year drop in EES because of the growth in the project business. This reflects a temporary effect that we discussed. We are currently experiencing the end of that bullwhip effect, and it's essential to recognize the significant supply chain disruptions caused by this pandemic, which are truly unprecedented. Analyzing the period from 2020 to 2023 reveals that while we've seen some bullwhip effects in previous economic cycles, this instance is notably stronger due to early pandemic conditions. Additionally, I want to point out that the industrial segment of EES saw robust growth this quarter, with a record backlog from industrial customers and record levels of bidding activity. Our integrated supply business, part of UBS and focused on industrial markets, also grew in double digits during this period. Overall, the industrial segment of our portfolio, prevalent in EES as well as in the UBS side, is strong. I previously mentioned that we are at the beginning of this industrial super cycle, driven by onshoring and supply chain consolidation, which is reflected in the substantial mega projects supporting electrification and increased automation.

Deane Dray, Analyst

Okay. John, thank you. I appreciate all that color and context. And I'll hand it back. Thank you.

John Engel, Chairman, President and CEO

Thanks, Deane.

Operator, Operator

And our next question comes from Sam Darkatsh with Raymond James. Please go ahead.

Sam Darkatsh, Analyst

Good morning, John. Good morning, Dave. How are you?

John Engel, Chairman, President and CEO

Hello, Sam.

Sam Darkatsh, Analyst

Dave, a couple of questions for you. So at least if my math holds. So it looks like pricing was down about 2% sequentially from the first quarter on a two-year stack and your decremental margins implied with your lower sales guidance are also pretty high. They're like 20%, 30% or so. Now I'm guessing, at least if my math holds, the reason why the decremental margins on the lowered sales guide are so high is because of the SVR, the incremental SVR pressure, now 40 bps instead of 20 bps prior. But are you assuming any sequential pressure in pricing in the back half versus the second quarter also contemplated within the guide?

David Schulz, Executive Vice President and CFO

Sam, we are. If you look at our year-to-date performance, we achieved a 5% increase in Q1 and a 3% increase in Q2. We anticipate positive pricing in the latter half of the year, although we expect it to step down further. We are confident in a 3% to 4% increase for the full year. From a pricing perspective, we have seen a decline in the number of price increase notifications as we progress through the year. For the second half, the number and the rate of those price increases are also lower compared to the previous year. Additionally, as I mentioned in the prepared remarks, we are facing headwinds in some pure commodity categories related to pricing.

Sam Darkatsh, Analyst

I think you're talking year-on-year, though, I was talking sequentially. Are you expecting lower prices in the back half versus the second quarter?

David Schulz, Executive Vice President and CFO

No, no. And again, for the commodities, you're right, it was a year-over-year comment in the prepared remarks. We don't project or predict what the commodities are going to do. But as we think about the pure supplier price increase benefit to our top line, it will continue to be positive, but less than what we have in the first half.

Sam Darkatsh, Analyst

Got you. And then my follow-up question. Can you remind us at this point what percentage of your overall backlog is EES versus UBS? And then same question as it relates to the inventory within your backlog, I'm guessing that's more overweight EES because a lot of UBS is direct ship. But can you put a little bit of help around the mix of your backlog right now between your segments?

David Schulz, Executive Vice President and CFO

Certainly. We've never detailed the specifics by strategic business unit within our backlog. There are different levels of project business, and it's important to note that only project business is included in the backlog. We haven't provided that breakdown. However, over the past couple of quarters, we've observed a decline in the CSS backlog, mainly because their supply chains are recovering more quickly than the rest of the business. The UBS backlog has remained relatively stable, although there has been a slight decrease compared to the previous year. We continue to see growth in the EES backlog, which constitutes about half of our total backlog. Despite some improvements in product categories due to supply chain issues, we are still experiencing extended lead times in certain categories, including switchgear within EES.

John Engel, Chairman, President and CEO

I mean that's an important point, Sam. I mentioned that lead times have come back to pre-pandemic level pretty much across the board in CSS. We've seen rapid reduction lead times for both UBS and EES as well across the majority of the portfolios. But we're still seeing well extended lead times for switchgear, which is part of EES, breakers and transformers in Utility, as well as rubber goods. So when you take those categories, we're talking about we're still seeing significant extended lead times. Think of it as more of the engineered components, the engineered subproducts and solutions.

Sam Darkatsh, Analyst

That's all I was getting at, John. I was trying to figure out, all right, if we wave the magic wand and switchgear availability is normalized and transformer availability is normalized, how much of your inventory can you monetize, can you liquidate?

John Engel, Chairman, President and CEO

Yes, that will accelerate our ability to ship against that backlog. We've been saying we expect backlog to come down sequentially, right? We've been very clear about that, because, again, that's the other end of the supply chain cycle as the lead times of collect. We're seeing that effect in CSS, those backlogs are coming down sequentially. We haven't seen that in EES yet or in UBS materially. But again, you're on the right point. As switchgear and the engineered components and EES, transformers and other engineered components in UBS come back to equilibrium, well, that creates an acceleration effect in terms of us being able to ship against our backlog and relieving inventory. Correct?

Sam Darkatsh, Analyst

But is there any quantification of that for some direct impact?

John Engel, Chairman, President and CEO

And I think it's completely a function, Sam, of how those lead times come in. We're still seeing a year-plus leads on gear and transformers.

Sam Darkatsh, Analyst

Okay. I'll defer to others. Thank you for the help.

Operator, Operator

Thank you. And our next question today comes from Nigel Coe with Wolfe Research. Please go ahead.

Nigel Coe, Analyst

Thanks. Good morning.

John Engel, Chairman, President and CEO

Hello, Nigel.

Nigel Coe, Analyst

Can you hear me okay? Hey, guys.

John Engel, Chairman, President and CEO

Yes, we can hear you.

Nigel Coe, Analyst

John, just want to go back to the bullwhip concept. Obviously, your suppliers are part of that bullwhip and arguably they should be more impacted by the sort of the inventory sequencing through the channel. So just would love your perspective on how some of your major suppliers like Schneider and Eaton, are showing mid to high teens growth in North America versus low single-digit growth for the use. So any perspective there would be really helpful.

John Engel, Chairman, President and CEO

On the latter part of the question, absolutely not. I know there's been some commentary and a bit of noise around that, but we're not seeing it. Our bid activity levels are at record highs. We highlighted a recent win in EES during our webcast, which is one of these newer mega project wins. This demonstrates how we won by providing a combined solution across various product categories and leveraging the strength of the broader WESCO. With our bid activity and customer engagement, I couldn't be more pleased. The opportunity pipeline we're managing is also at a record level, including more comprehensive solutions where we're cross-selling within each SBU, thanks to the WESCO Anixter merger, and increasingly across the SBUs. I believe we are uniquely positioned with our portfolio to offer complete solutions and be a one-stop shop for these larger mega projects. Regarding the final part of your question, I haven't seen any evidence of that, nor do I expect to. I've been in this industry for over twenty years, and there's always been a segment of engineered components and products that goes direct instead of through distribution. That dynamic isn't new. As for your first question, I generally won't discuss individual suppliers or competitors, but I encourage you to consider our entire supplier base. We have large suppliers for our Electrical, Utility, Communication, and CSS businesses. Analyzing the complete composite reveals various trends. When looking at our CSS business and its major suppliers, there is a significant difference in growth rates compared to us. We're at the other end of that supply chain whipsaw effect. In the Utility sector, one particular supplier serves both Utility and Electrical, and their reported results this quarter align well with ours, serving as a good proxy. Additionally, other large electrical suppliers work through us while a global competitor handles another major supplier. Their growth rates indicate that we're in the same range in terms of results. To conclude, our project sales increased this quarter, while stock inflow has decreased. Our key Electrical suppliers have two aspects to their business; they supply our stock and flow through our purchases and also manage project business that goes both through and around us. We're observing strength in our project business and believe we are at the forefront of that super cycle.

Nigel Coe, Analyst

Thanks, John. There's a few more pieces to the jigsaw there, so thanks for the help there. And then, Dave, just my follow-on is just look at the math you gave on the back half sequential, which is really helpful. It looks like you're implying sort of year-over-year growth in 3Q and 4Q of roughly 2%, 3% organic, I think it is. Number one, is that correct? And then thinking about that July prelim sales of 3%. If we take out Rahi, it looks like organic is closer to 1% to 2%. So just wondering the confidence that we have that organic accelerates from July into the back half of the year.

David Schulz, Executive Vice President and CFO

We are very confident. The way you framed that mathematically is absolutely correct. Looking at our first half results from organic sales compared to our full year outlook, we expect to see EPS growth in the second half of the year. We also anticipate continued strong performance from both our CSS and UBS businesses, which had a very successful first half. From our perspective, July was a mixed month. The first couple of weeks were quite slow, but the latter part of the month showed significant improvement across all of our businesses. We have taken the July results into account, along with our expectations for each operating group, to shape our outlook for the second half.

Nigel Coe, Analyst

Okay. Thanks, Dave. Thanks, John.

Operator, Operator

Thank you. And our next question today comes from Christopher Glynn with Oppenheimer. Please go ahead.

Christopher Glynn, Analyst

Thanks. Good morning, guys. I had a question on free cash flow. A lot of times a little lower sales outlook enables a higher free cash flow in the distribution model and particularly with the past couple of years, investment in inventory growth. So curious what the rub is there.

David Schulz, Executive Vice President and CFO

Yes, Chris, it's Dave Schulz. So one of the things that we indicated was we do expect our fourth quarter to be sequentially stronger than the third quarter. So a lot of this will be the timing of the sales that we have in our outlook by quarter. And given the stronger sales that we would expect in the fourth quarter that would lead to a higher receivables balance. So that is a drag on our typical model where we would see seasonal declines in the fourth quarter, therefore releasing more net working capital. We've built into our outlook that we don't expect that to happen this year at the same level.

Christopher Glynn, Analyst

Okay. So would you expect that set up for a particularly strong free cash flow next year, again, given the backdrop of a couple of years of pretty pronounced working capital growth?

David Schulz, Executive Vice President and CFO

That is correct. Typically, we see our first quarter sales down sequentially versus the fourth quarter. Depending on the timing of projects, we would expect to release that accounts receivable build in the fourth quarter.

Operator, Operator

Thank you. And our next question today comes from Steve Volkmann with Jefferies. Please go ahead.

Stephen Volkmann, Analyst

Great. Good morning, guys. Just a couple of kind of follow-ups here. Dave, how are you thinking about opportunities to pay down some of the sort of higher coupon debt? I know it's not due for a year or two. But are there ways to do that in the shorter term?

David Schulz, Executive Vice President and CFO

Yes, Steve. We're always looking at what are the opportunities for us to refinance. We do have a $1.5 billion note that is maturing in 2025. And we've talked about this previously that now that the break fees for calling that bond or further reduced, we're always looking at that. It's really the difference between the break fees versus the interest rate arbitrage. So that is something that we're looking at consistently.

Stephen Volkmann, Analyst

I'm curious about how we should view the project wins and mega projects you've mentioned. We all recognize the potential there, but how should we assess the margin mix as these projects begin to roll out? Are they likely to have lower gross margins but also lower SG&A expenses? I'm trying to understand how this dynamic will unfold over the next couple of years.

John Engel, Chairman, President and CEO

That's a great question. Yes, parts of fulfilling the project demand will come from our stock and flow. However, some engineered components and solutions will be shipped directly from our supplier partner to the construction site. When this direct shipping method is used for a specific category, it generally results in lower gross margins. Nevertheless, the operating costs associated with this business model are also lower, so we are fairly indifferent at the EBITDA margin line. I wanted to emphasize that point. Another important note is about our backlog. We usually receive questions regarding the margin of what’s in backlog and its trend, which remains strong and has actually increased slightly. This indicates the effectiveness of our value-based pricing and margin improvement strategies, especially as we secure larger projects with expanded scopes, some of which have longer durations. We are enhancing our value proposition beyond just product offerings, including services, which helps us better meet customer commitments and improves our ability to charge appropriately.

Stephen Volkmann, Analyst

Great. That's helpful. And then just a final quick one. I think you laid out sort of a long-term target, 100% free cash flow to net income over sort of a longer period, and we can all sort of try to guesstimate sort of what's what quarter-to-quarter. But are you still committed to that sort of long-term 100% free cash flow target?

John Engel, Chairman, President and CEO

100% committed. If you look back at the company, let's just go kind of premerger close back in 2020, and you were to look back on a five or 10 year cumulative basis, legacy WESCO averaged over 100% of net income, free cash flow and Anixter was right in the same zip code. So the answer is absolutely, yes, together. I think, obviously, this pandemic has driven some unique, let's call it, some unique results in our business on how we had to manage the supply chain and our inventories through the most disruptive period, the front end of it. I mentioned as bullwhip effect at the back end of it. But as we get back to equilibrium, with the power of our portfolio, the scale in particular, and the digital transformation that we're executing that we haven't talked a lot about that, fundamentally, that will improve our ability to increase our working capital terms, in particular inventory. So I'm not raising the 100% of net income. I'll just tell you that we have shown with a long successful track record of consistently doing across the entire economic cycle. What's new is, as we put these two companies together with our scale and this digital transformation, we think we'll have increased cash generation opportunities versus what either company could do on a premerger basis once the digital transformation is complete. We'll leave that for a future discussion because that will be a bit out there. But in the short to medium, yes, the 100% were locked and loaded as a commitment.

Stephen Volkmann, Analyst

Great. Appreciate the color. Thank you.

Operator, Operator

Thank you. And our next question comes from David Manthey with Baird. Please go ahead.

David Manthey, Analyst

Thank you. Good morning, everyone.

John Engel, Chairman, President and CEO

Hello, David.

David Manthey, Analyst

First off, John, you mentioned that you expect to return to growth in EES in the second half, and then you further said you expected to double-click on those EES trends. So just wondering if you can give us some color on trends within the three subsegments of EES and how you see those playing out in the back half, OEM, industrial construction.

John Engel, Chairman, President and CEO

Thank you. I'll start with Industrial. We are seeing strong momentum in the first half, a robust opportunity pipeline, and an increased backlog, which we expect to continue. I believe we are at the beginning of an industrial super cycle. Therefore, we are very optimistic about the industrial segment of the EES business. Regarding construction, the backlog has grown sequentially, which gives us confidence in the opportunity pipeline and the successes we are achieving. As we noted in the last two quarters, we anticipated a sequential decline in EES backlog as we began to utilize it; however, that has not occurred yet. We expect strong contributions and growth from the project segment of EES that supports the construction value chain. In response to Deane's question, we believe the temporary supply chain disruptions affecting the stock and flow business will persist through Q3 but will significantly improve moving into Q4. When it comes to OEM, the manufactured structures sector is cyclical and is expected to experience a downturn in the second half of this year. However, the overall OEM balance, which services various industrial end markets, including semiconductor, remains promising. As we progress through the second half and into next year, we are very optimistic about the solution capabilities of our OEM business.

David Manthey, Analyst

That's helpful. Thank you. And then just for completeness here. What percentage of EES segment revenue specifically or stock and flow?

David Schulz, Executive Vice President and CFO

David, it's Dave Schulz. So right now, our stock and flow business is running about 60% on our EES business.

Operator, Operator

Thank you. And ladies and gentlemen this concludes our question-and-answer session. I'd like to turn the conference back over to Mr. Engel for any closing remarks.

John Engel, Chairman, President and CEO

Well, thank you all. We are at the top of the hour. Thank you all for your support. It is much appreciated. We look forward to speaking with many of you. I know we have many calls scheduled over the next several days. And also, over the next two months, we have a robust schedule. We will be participating in the Jefferies Industrial Conference, the RBC Global Industrials Conference and the Morgan Stanley Laguna Conference during the third quarter. Thank you all for joining our call. Have a good day.

Operator, Operator

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.